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For pre-seed and seed stage startups, investor updates are a challenge. Often, founders try to make them too ornate and end up getting behind. Similarly, investors don't always have the time to fully digest a finely crafted narrative and lose track of what's happening. At RSCM, our portfolio of pre-seed and seed-stage investments is at about 2000 today, so we have lots of experience with updates. Not only do we read them all, we write a 3-7 line internal summary and each one goes into our CRM system so we have a complete history at our fingertips.In my opinion, useful investor updates have three requirements: they must get done, they must be easy to produce, and they must be easy to consume.

Anatomy of an Update

You can deliver on all three requirements by breaking updates into modules and putting the most important modules first. That way, you need only produce the modules you have time for and we need only consume the modules we have time for. Everybody wins.Here are the modules and order I recommend:

[Company Name] Investor Update for Month Ending [Last Day of Month]

• Metrics
• Highlights (Optional)
• Asks (Optional)
• Thank Yous (Optional)
• Commentary (Optional)

Notice that the only required module is "Metrics". This should be easy to produce because, at any given moment, you should have a handful of Key Performance Indicators (KPIs) you track anyway. This should be easy to consume because most investors have lots of experience absorbing tabular business data. This should be easy to get done because, in our modern software-driven world, KPIs are at your fingertips. Most importantly, if they are the metrics you are actually tracking to run your business, then they will be reasonably informative to investors. Requirements satisfied!More detail on metrics in a minute, but first some quick notes on Highlights, Asks, and Thank Yous. If you opt to include these modules, do them as bullets. Easier to produce and easier to consume. But, as with PowerPoint slides, no more than 7 bullets per section! Even then, only go to 7 on rare occasions. No more than 5 most of the time. It's easy for people to get saturated and when they get saturated, they flush the entire list from their attention. If you've got more to say, put it in the Commentary.Everything after Metrics really is optional. Better to get the update out the door quickly than wait until you come up with points for every section. If you ever find yourself thinking something like, "I'll crank out the Asks later," stop! Just hit send. Then if you do think of important items later, put them in a notes file and include them in the next update. Or send out a specific Asks email.

Universal Metrics

Now for some depth on metrics. There are really two types: (1) those that are universal to all pre-seed/seed startups and (2) those that are particular to your business. Investors need both. The first type gives us a general sense of how things are going for you relative to the typical startup lifecycle.  Kind of like the vital signs that all doctors want to know regardless of patient or condition.  They help us triage our attention. So start with them:

• Revenues: [revenues | date when you plan to start selling] (+/- ?% MoM)
• Total Expenses: [expenses] (+/- ?% MoM)
• Net Burn: [total revenues - total expenses] (+/- ?% MoM)
• Fundraising Status: [not raising | planning to raise | raising | raised]
• Fundraising Details: [how much, what structure, valuation/cap, who]
• Ending Cash: [last month's Ending Cash - this month's Net Burn + this month's Amount Raised] (+/- ?% MoM)
• Full Time Employees: [FTEs, including founders] (+/- # MoM)

Note 1: we strongly encourage a monthly update cycle. Anything longer means we get data that's too stale. Anything shorter, and the financial metrics don't really make sense. Though if you're part of an accelerator that encourages weekly updates, we'd love to see them. Just make sure we also get the monthly metrics!Note 2: always put the percentage or absolute month-over-month changes in parentheses next to each entry. It turns out that highlighting the deltas make updates dramatically easier for us to absorb by drawing immediate attention to the most volatile areas.A couple of quick explanations. Always have a Revenues line. If your product isn't finished or you aren't actively trying to generate revenues, just put the target date for when you do plan to start selling. Either piece of information is enormously helpful to us. Also, provide an FTE number that logically reflects the labor resources at your disposal. A full time contractor is a unit of full time labor that you can call on. Two half-time employees are also one unit. An intern may or may not be a unit or fraction of a unit depending on how much time he/she is putting in and whether the output is roughly equivalent to what a regular employee would produce. Don't exclude people based on technicalities, but don't pad your numbers either.Now, some detail about fundraising status. This topic turns out to be pretty important to existing investors. First, it lets us know that you're on top of your working capital needs. Second, some investors like to participate in future rounds and even the ones that don't are a great source of warm leads. Third, it makes us feel good to know that other people have or will be validating our previous investment. Here are a couple of example fundraising bullets:

• Fundraising Status: planning to raise in 4Q2015
• Fundraising Details: $750K - $1M Series Seed at a $5M-$6M pre-money from a small fund and/or local angels

• Fundraising Status: raising
• Fundraising Details: $300K - $500K on a convertible note at a $2.75M cap with $175K soft committed from [prominent angel name] and other local angels

• Fundraising Status: raised and raising
• Fundraising Details: $400K closed of a $600K convertible note at a $4M cap from [small fund name], [AngelList syndicate name], and local angels.

Custom Metrics

At any point in time, there should be a handful of top-level KPIs that you monitor to help run your particular startup. Of course, they vary across lifecycle stage, technology area, and business model. Just pick the most important 2-6 and give them to us. Feel free to change them as you pivot and mature.Here's an example for a pre-product enterprise SaaS company:

• Projected Alpha Delivery Date: 11/30/2015 (+15 days)
• Alpha Access Wait-list: 47 Companies (+8)

And one for an enterprise SaaS company that recently shipped private beta

• Max Queries/Minute: 1,201 (+29% MoM))
• Outstanding Critical Bugs: 3 (-2)
• Inbound Inquiries: 481 (-17% MoM)
• Qualified Prospects: 19 (+2)
• Paid Pilots: 3 (New Metric!)

And finally one for a consumer Web company in full operation

• Max Concurrent Users: 1,006 (+30% MoM)
• Registered Users: 23,657 (+13% MoM)
• Monthly Actives: 3,546 (+4.5% MoM)
• Users Making Purchases: 560 (+21% MoM)
• Total Purchase Value:$17,993 (+28% MoM)
• CAC: $12.55 (-7% MoM)

That's it. We estimate that, if you keep your accounting system up to date and use MailChimp, producing an update with metrics and a few extra bullets should take about 15 minutes (with some practice). And you'd be heroes in our book.  Well, all entrepreneurs are already heroes.  So you'd be superheroes!

This post originally published on 10/15/2015 and was last updated on 11/10/24.

People sometimes ask us, "What's the #1 mistake startup founders make?" Based on our 2000 pre-seed portfolio companies, one of the prime candidates is: "Planning for Series A."I don't mean the way you plan for Series A. I mean the fact that you do it at all. We see a lot of pre-seed pitch decks. A decent fraction have a "Comparables" section that list the Series A raises for companies with similar models in the same industry. In these cases,  Series A has become an explicit planning goal, despite the fact that these companies are at least two rounds, and probably three or four, away from that milestone. But the prevalence in pitch decks vastly understates the issue. From systematically interviewing 800+ founding teams in accelerators, it's clear that Series A expectations play a substantial role in most founders' planning.

While completely understandable, even considering Series A at the accelerator stage is usually a huge mistake. As I've written before, taking Series A at the point where it's appropriate decreases your success rate (though increases your expected value). Unsurprisingly, actually working backward from a future Series A can create all sorts of planning pathology. Yes, TechCrunch makes a big deal out of Series As. Yes, lot of cool VCs blog about Series A. Yes, VC investment leads to pretty fantastic story lines on "Silicon Valley". But these sources of information inherently screen for outliers. It's still the exception. Even among successful tech startups. Fundamentally, you're trying to engineer an extreme outcome in a highly uncertain environment. On first principles, this is problematic, as Nassim Taleb so beautifully explains the The Black Swan. But let's work through the steps.

Start with a modern Series A of roughly $10M as your goal. OK, those VCs will want evidence that you can quickly grow past the $100M valuation mark. That means you'll probably need about a $3M Series Seed 12-24 months beforehand to build the necessary R&D, sales, and customer success scaffolding, as well as prove out a huge addressable market. This in turn implies a $1M angel round coming out of an accelerator to complete the full-featured version of the product and establish a firm beachhead market over the next 12-18 months.

Now, I can tell you from reading the investor updates for 2000+ pre-seed startups that such rounds are very hard to raise... unless you're a strongly pedigreed founder, have obviously anti-gravity level technology, or have crazy traction in a hot space. We like to say rounds at this stage have a "geometric" difficulty curve. A round that is twice as large is four times as hard to raise.

Even if you manage to raise that round, the failure rate at each subsequent stage is high because you're continually striving to achieve outlier levels of growth. There's not much room for error or setbacks.  It's like trying to run up a ridge that just keeps getting steeper and narrower, with a sharp drop into the abyss on either side.

So what's the alternative? We recommend you ask yourself, "What's the smallest early acquisition (but not just acqui-hire) that I'd be satisfied with?" Unless you have a significant previous exit, are already very wealthy, or have unusual risk preferences, this number is likely somewhere between a $10M and $35M acquisition where the founders still own about 1/3 to 1/2 the company. Then work backwards from that.

Now, you may be saying to yourself, "Wait a minute! If I could get acquired for $10M to $35M, I could get a Series A. It's the same thing." Not exactly. $20M is a typical Series A pre-money these days, at least from a traditional name firm. But you would also need to be able to demonstrate that you could quickly grow to be worth $100M+. And you usually get a bit of a premium on acquisitions. So it's only at the upper end of the range where a Series A would be a fit, and then only some of the time.

Importantly, acquirers mostly want to see a great business or great technology and Series A investors mostly want to see enormous growth potential, which often aren't quite the same thing.

Finally, Series A investors usually want to see extremely rapid past growth, as an indicator of rapid future growth. Acquirers care much less how much time it took you.Also, the cost of being wrong is asymmetric. Say you aim for Series A from the outset. If at any point it doesn't work out, you either fold or do a fire sale. In a fire sale, liquidation preference will kick in and founders will get zilch anyway. Conversely, say you go the smaller route and things go much better than expected. You can still "upgrade" to the Series A path. And if you go the smaller route and fail, there's some chance you'd still make a modest amount in a fire sale or acqui'hire.

So now let's work backwards from the acquisition. We'll assume that revenues, rather than technology capability, is the relevant metric because it makes the reverse induction more clear cut.

1. In most tech sectors, a $10M to $35M acquisition means $1M to $3M per year in margin (not gross revenues, though in some sectors, the margins are so high, it's the same thing). That's low $100Ks of margin per month.
2. Next, we like to think in terms of the "straightforward scaling factor". This is the multiple by which you can grow with straightforward scaling of your product development and sales machines. No major overhauls of the product, no completely new channels, and no huge breakthroughs. Basically keep doing what you're doing, but with more resources. In most segments, this factor is 3-4X for a target in the $100K/month order of magnitude. Obviously, it's not a sure thing. Bad things can still happen. It can turn out that you've made a mistake. But it's the difference between needing circumstances not to go strongly against you and needing circumstance to go strongly for you. That works out to $20K to $80K per month, depending on scaling factor and target outcome. Thus, your near-term goal becomes, "Build a business doing $20K to $80K per month in margin."
3. If your minimum acceptable exit is on the higher end and your scaling factor is on the lower end, you might want to break this stage into two (though your might want to ask yourself why your minimum is higher given the lower scaling factor). In most cases, the first step therefore reduces to, "Build a business doing $20K to $40K per month in margin."

This is often a very achievable goal with a very modest amount of capital. How do you go about raising a round to support achieving this goal? Well, we have a post for that.

It's worth noting that, in terms of our expected returns, it doesn't matter too much to us one way or another whether founders follow this plan. Our funds have many hundreds of companies, so we're expected value decision makers. Though there is also some argument to be made for preserving option value by having companies survive longer. But it's not a huge difference either way at our level of diversification.

However, for founders who can only do a handful of startups in their career, understanding the difference between success probability and expected value could be literally life altering. And don't forget, once you have a modest exit under your belt, you've got the pedigree! So it's much easier to command the resources and attention necessary to go big from the start on the next one.

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This blog post originally published on 12/10/2020 and was last updated on 10/14/2024.

The venture market bottomed out from historic highs last year. Total deal volume slumped roughly 50% from 2021’s peak, exit activity hit a ten-year low, and venture fund performance dropped across the industry. These rapid changes have created a new landscape for venture capital, and it’s affected how VCs are investing.

Right Side Capital surveyed 110 Pre-Seed and Seed VCs from February 2024 to May 2024 on their investment activity and strategies in 2023 and their plans for 2024, with a focus on Pre-Seed Rounds and Seed Rounds. VCs revealed that they are optimistic about the funding landscape in 2024 and that they have high expectations for revenue levels and growth rates from portfolio companies.

Below we share what we learned.

VCs Were Active in Pre-Seed Rounds in 2023

Surveyed VCs revealed that they were fairly active in Pre-Seed investment last year. Of the VCs surveyed, 87.0% made at least one investment in round sizes of $1M to $2.5M, and 35.2% made more than five investments at this stage.

Seed Round Deal Volume Was Less Than Pre-Seed Round Deal Volume in 2023

VCs reported less deal volume in Seed Rounds in 2023 as compared to Pre-Seed Rounds during the same period. Only 12.1% of surveyed VCs made more than five investments at this stage, and 25.9% made no investments at all. The majority (62.0%) made between one and four investments at this stage.

Investment Outlook Is Optimistic in 2024

Nearly half (45.4%) of respondents plan to make five to nine new investments in 2024, which is a significant increase from 2023, and 24.1% said they planned to make 10 or more investments this year. All respondents planned to make at least one investment, which indicates a more positive outlook from 2023.

Pre-Seed Fundraising: What VCs Expect from Founders in 2024

At the Pre-Seed fundraising stage, only 46.3% of surveyed VCs will invest in a pre-revenue startup, 27.4% will invest in a startup with sub-$150K annual recurring revenue (ARR), and 14.7% require $150K – $499K in ARR. For some surveyed VCs, revenue expectations can be even higher: 11.7% said they required startups to have $500K or more in ARR.

Growth expectations are high for Pre-Seed Rounds, with 34.8% of surveyed VCs expecting startups to double year over year at this stage, and 37% expecting startups to triple year over year.

Seed Fundraising: What VCs Expect from Founders in 2024

Expectations vary a lot for startups raising their seed rounds. At this stage, 17% of surveyed VCs will invest at pre-revenue, but 24% want to see ARR of $1M or more. That’s a big change from four years ago, when $1M or more in ARR was the criteria for Series A funding.

Surveyed VCs expect aggressive growth at this stage, with 47% investing in startups that are doubling year over year and 34% investing in startups that are tripling year over year.

Most VCs Recommend 6-12 Months of Runway

The majority (53.7%) of surveyed VCs advise their portfolio companies to maintain six to twelve months of runway before raising their next round. Only 29.6% of VCs advise startups to have over 18 months of runway.

Capital Efficiency Is More Important Than Ever

VCs reported that, in this leaner landscape, they are placing a greater emphasis on capital efficiency for portfolio companies. For 81.5% of respondents, capital efficiency is more important than ever before. The survey included an option for respondents to indicate that capital efficiency was unimportant, but not a single respondent selected it.

Roughly One Third of VCs Have Changed Their Investment Thesis

We asked respondents to write in answers about how their firm’s investment thesis has changed in 2024. Below we break down the results of those write-in answers.

Summary of Investment Thesis Changes in 2024

No Change (58%) The majority respondents indicated that their investment thesis has not changed significantly from 2023.

More Focus on Specific Areas (15%) Some VCs have an increased focus on specific sectors such as health, cyber, AI, and cybersecurity. They’re putting a greater emphasis on software, particularly AI-powered applications, and avoiding certain sectors like consumer and hardware.

“Like everyone else, [we have] more interest in AI-powered applications.”

– Survey respondent

Adjustments in Investment Strategy (10%) Some VCs are shifting to smaller check sizes. They indicated more capital allocation for Pre-Seed and they are rightsizing investment amounts to achieve more significant ownership.

Greater Sensitivity to Valuations and Due Diligence (7%) VCs are more sensitive to valuations, ensuring companies have more runway, and conducting more thorough due diligence. They’re also focusing on financing risk, revenue, traction KPIs, and efficient use of capital.

“[We’re] thinking more about financing risk and making sure companies have more runway.”

– Survey respondent

Increased Sector Preferences and Deal Dynamics (5%) A small subset of VCs have a growing preference for companies with experienced founders, significant revenue, and efficient burn rates. They’re avoiding overinvested spaces like sales-enablement software and sectors that are seen as high risk for next-round funding.

“[We’re] rarely taking pre-product risk unless the team has prior operating experience.”

– Survey respondent

No Specific Answer or N/A (5%) Some responses were “N/A” or did not specify a change in investment thesis.

Final Conclusions from the RSCM 2024 VC Survey

The venture capital landscape in 2024 has adapted to a leaner and more cautious environment. Right Side Capital’s survey reveals a higher bar for revenue expectations and a greater emphasis on capital efficiency than in more bullish periods.

Despite the challenges of 2023, VCs are optimistic about 2024 and plan to increase new investment volume. Overall, VCs are adopting a resilient and forward-looking approach, emphasizing sustainability and capital efficiency to navigate the transformed economic landscape.

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Founding a company is challenging enough without also heading your sales process. But Kelvin Johnson, the CEO and co-founder of Brevity, believes that leading sales is an opportunity for founders to get to know their customers. He’s developed a five-step sales process that tailors to a prospect’s pain points and adapts to his customer’s needs, while also allowing him to learn his Ideal Customer Profile (ICP) and build trust.

In a recent webinar for Right Side Capital Managment’s portfolio companies, Kelvin sat down with RSCM’s “Sales Doctor” Paul Swiencicki to share how he’s used his founder-led sales process to drive $600K in annual recurring revenue (ARR) for Brevity’s core product, an AI-powered sales role playing tool.

Below, we outline Kelvin’s sales process and highlight some of his key insights.

Step One: The Qualification Call

Kelvin uses a qualification call to kick off his relationship with a prospect to determine if his product will be a good fit for them. He makes sure the call takes place before any additional time is spent on the sales process. “We start off these conversations by asking, ‘What piqued your interest to even take this call?’ and ‘What will a successful outcome look like at the end of our 30 minute conversation?’ So at least we have an anchor point as to what’s important to them,” says Kelvin. “We may have our own agenda, but I really want to figure out what is important to this prospect. And I want to make sure we maximize our time.”

Qualifying leads is a critical part of sales success. A founder’s time is best spent on  prospects where their product can make a big impact. “At first, we weren’t doing a great job of qualifying our leads. But over time, we ended up discovering that our best ICP is somebody that’s at the sales manager level or above, who oversees at minimum 10 sales reps. That’s where it starts to make sense for us,” says Kelvin. “You’ve got to qualify hard to close easy.”

Step Two: The Custom Test Drive Demo

Kelvin has learned that a demo is much more effective when he caters to a prospect’s specific pain points. He schedules a “call before the call” in advance of a demo to gather information. “In the call before the call, we’re trying to figure out where a prospect is experiencing the greatest friction, what initiatives they have in place to alleviate that friction, and what have been the results of those initiatives,” says Kelvin. “We’re also trying to get into the weeds of what key success metrics matter the most to them, a.k.a., ‘How do you plan to justify this investment internally?’”

Once he knows what’s important to his prospect, he can give them a customized demo. Demonstrating he paid attention is also a great way to build trust and strengthen his relationship with the prospect. “You have to shut up, listen, and then here’s the most important part: As soon as you hear what the customer says, that’s the only thing you demo,” says Paul. “What I find is that everyone just does a spray and pray demo. It’s all just one size fits all. That’s not what prospects want. The first thing you have to demo is what they said their problem is. Otherwise, they’re not going to listen.”

Step Three: The Business Justification Review

After the demo, Kelvin sends the stakeholders a document that captures everything he’s learned about them thus far. The document outlines their problem, what they’ve already tried, the outcomes and results of those past solutions, what they stand to gain by using Kelvin’s product and, most importantly, what they stand to lose if they do nothing. “One of the most important sections in the document is about the cost of inaction – the lost revenue calculator,” says Kelvin. “The biggest thing we’re all competing with is doing nothing.”

He then schedules a call to go over the document with the stakeholders, so he can put all of the relevant information in front of the prospect in one tidy package. “This makes our champions look so good when they present to their CFO along with a supporting Excel sheet that shows them the cost of doing nothing, of not buying our product. That shows them why they need to start now,” says Kelvin.

Step Four: The Kick-Off Call

Kelvin is thinking about retention before he’s even closed the deal, which ultimately leads to higher ARR. Research has shown that retaining customers is cheaper than acquiring new ones and that improving retention by just 5% can drive profits up over 25%.

Kelvin sends the prospect a plan for implementation that sets expectations and shows clear milestones and goals. “We understand how overwhelming new software can be,” says Kelvin. “I’m trying to break it down into very digestible pieces.” He asks his new customer two questions: “Before the end of our renewal process, what are you going to brag to your board about?” and “What is one high-impact scenario where we can deliver first value?” Kelvin and his team can then have a kickoff call that caters to these primary objectives.

Step Five: The First Value Check-In

About one month after closing the deal, Kelvin schedules a call with his new customer to ensure they’ve hit their initial goal. “Our average customer is getting to first value within 17 days. Not because they’re focusing on uploading their entire sales playbook into our roleplaying software. No, no, no. We’re focusing on one high impact, high stakes, high frequency scenario,” says Kelvin.

From there, Kelvin can work with the customer to expand Brevity’s usage and ensure the customer is getting what they need. “I tell them, ‘It’s our job to make this simplified for you and your team,’” says Kelvin. “Everybody learns how to maximize the utility of the software within the first month. And then once we’ve nailed that, then we get to show ongoing value.”

A Repeatable Process for Building Revenue and Trust

Kelvin’s five-step sales process is a testament to the power of personalized engagement. It emphasizes active listening, customized demonstrations, and transparent communication that not only fosters trust but also ensures alignment between Brevity’s solution and the customer’s needs. By implementing Kelvin’s strategies, you can not only increase your chances of closing deals but also establish credibility, laying a solid foundation for a long-term, successful partnership.

Want to get more expert advice for your startup? Apply for funding from Right Side Capital to gain access to take part in our community of 1800+ founders and gain access to a host of free services including go-to-market, sales, marketing and fundraising advisory.

About Right Side Capital

Right Side Capital is one of the most active VC firms investing in the Pre-VC stage, partnering with 100+ capital efficient tech companies in the USA & Canada every year at an average round size of <$500K.

As a team of former founders and operators, we know that founders tackle problems that are equal parts challenging and inspiring. Building on our 12 years of experience with 1800+ portfolio companies, we’re changing how early stage startups receive funding and support.

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RSCM is different from the vast majority of startup investors.

We are one of the only ones that is completely transparent on our Web site about our criteria and completely open access to any founders that think they meet them. Then we are fast. We make decisions in days and fund in weeks

If you’re familiar with how other investors work, you might find our behavior confusing. But once you understand our perspective, you’ll hopefully appreciate the rationality of our approach.

We look at the investment process like engineers:

• There are very large numbers of both startups and investors.
• The probability of any particular startup and any particular investor overlapping in their requirements is small.
• Startups and investors both want to find the best match.
• Time is valuable.

Conclusion: as an investor, (1) you want to be very up front with your target profile so startups outside this target don’t waste their time with you and (2) if you’re going to pass on a deal, you want to do so as quickly as possible. The later in the process you pass, the higher the cost to you and the startup. If you fail a high percentage of deals near the finish line, you’re doing it wrong.

When we analyzed and observed other investors, it seemed like two large sources of rejection frequently occurred at the very end of the process: outside of scope and disagreement on valuation. Investors would spend an enormous amount of time learning about a startup’s technology, business, and team, only to say, “No,” because they didn’t feel the investment ultimately matched their thesis or the founders wanted too high of a valuation.

Ideal Profile

To address the first category of failure, we made a list that defined our ideal profile and stuck to it. That may sound simple in theory, but it turns out to be extremely difficult in practice due to “fear of missing out”. Our goal was to come up with a set of criteria so crisp that we would never invest outside its boundaries and would invest in anything within its boundaries at the right price. Obviously, such perfection is impossible, but we are far closer to this ideal than everyone else.

Our list is not very long:

1. Must be a “technology startup”.
2. Must be “capital efficient”.
3. Must be looking for an investment of no more than our maximum round size.
4. Must be looking for a valuation of no more than our maximum valuation.
5. Must be located within our investment geography.
6. Must not be in one of our excluded business areas.
7. Must meet our minimum traction bar.
8. Must have a minimum number of FT founders..

Obviously, the parameters of each requirement can evolve. But it’s easy to declare them at any point in time, at least for (3)-(8).

Defining a “technology startup” is more subtle. For example, Internet auction sites and bookselling sites were “technology” in 1995. In the 2020s, not so much. What about a company that makes clothing from advanced materials manufactured by someone else and then sells it on Amazon? We would look at this business and conclude that their value add is the design of the clothing, so it’s fashion not technology. A similar analysis applies to resellers, who may sell extremely technical products, but their specific value-add is not the technology in those products.

Then there’s the issue of “technology-enabled” businesses–ones that apply technology internally to deliver a non-technology product such as car repair or temporary workers. In these cases, we consider how much technical advancement the startup has achieved and whether its business is likely to scale dramatically better than it would without the technology enablement. For example, if the technology enablement were superficial and easy to imitate, we would be a no. If the business required building or customizing specialty facilities at scale, also a no. If the differentiation were branding or fashion, no.

In general, we try to predict whether the business would scale rapidly due to its technological advantage and whether the exit market would treat the business as technology, with its associated high valuation multiples. Obviously, these touchstones are imprecise, but at least they provide a framework for making a determination.

The definition for “capital efficient” is also fuzzy. The underlying issue is that, the more capital a company needs to prove out its business, the more vulnerable it is. Also, when you’re an early investor that doesn't follow on, there can be structural challenges with large subsequent rounds that occur before a company has achieved product-market fit. The question we ask ourselves is, “Could this business reasonably get to breakeven, if necessary, with only $1M to $2M in total investment?” That doesn’t mean we don’t want companies to take more money; we just want them to have the choice and negotiating power of not needing large future rounds.

Valuation Up Front

Addressing the second challenge of avoiding mismatched valuation expectations is trickier. Any solution requires calculating at least a narrow range for the acceptable valuation up-front and at low cost. Initially, we developed a basic algorithm using parameters like founder experience and stage of technical development. This algorithm worked well enough to make us far more nimble than other investors, but required substantial qualitative judgment to determine the input value for each parameter. 

Then, a few years after we started investing, startups in our price range started routinely having initial revenues. We quickly realized that we could key valuations off these revenues. While more objective than our first algorithm, this path presented two sub-challenges.

The first sub-challenge was determining whether focusing on revenues would produce “negative selection”. It’s theoretically possible that the startups with the most potential to have very high returns are those working on groundbreaking products that take longer to reach a salable stage. In fact, there was also some conventional wisdom to this effect. However, there was also conventional wisdom from the “Lean Startup” movement that advocated getting some version of the product into the hands of customers as soon as possible.

When we analyzed our portfolio up to that point, we determined that several factors argued strongly for early revenues being a net positive:

• Burn. Startups at our stage seemed to typically burn $10K to $20K per month. Revenues of even $5K per month could extend runway 33% to 100%. Because we fundamentally believe that the earliest startups represent option value, revenue that extended runway should increase this value.
• Business. Having some customers willing to pay something is a positive sign that the startup is in a general area that might be a good business. Also, founders that are able to convince people to pay now is some indication that they’ll be able to convince people to pay more in the future. Finally, achieving initial revenue quickly and at relatively low cost is a signal of capital efficiency.
• Innovation. Having customers to test new features on and ask about broader needs is a valuable source of insight. People who pay money are a more reliable source of opinion because they have skin in the game.

The second sub-challenge was how to deal with different revenue models. Obviously, a company that sells a piece of hardware at 50% margin and then a bunch of professional services is quite different from a SaaS company with customers on annual contracts at 90% margin. After reviewing our portfolio to that point, we were able to construct a set of rules that accounted for these differences:

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1. Only revenues from the technology product or service count. No professional services revenues.

1. Only gross margins count. 
2. Growth path matters. A startup that reaches $10K/month in three months since launch is more attractive than one who took a year to grow from $1K to $10K.
3. Recurring matters. Customers on annual contracts are better than ones on month to month contracts, which in turn are better than those who pay once. Generating revenues from a spot market, such as an ad or affiliate network, is the least attractive.
4. Price point matters. At low price points, the sales channel must be very scalable and the acquisition costs pretty low. At higher price points, there is more room for error.
5. Sales channel matters. The lower cost and more scalable the channel, the better.
6. Acquisition cost matters. The less it costs to acquire a given amount of revenue, the better.
7. Revenue concentration matters. Having more than one enterprise customer or customer segment is more attractive.

With these rules, we can look at a startup’s revenues in the context of our historical deal flow and determine our valuation tolerance. Obviously, if we happen to have several recent deals with identical revenue characteristics, we can determine the valuation easily. But the above rules also allow us to make tradeoffs versus recent deals with different characteristics. For example, a company that is otherwise similar at half the price point would be worth a modest amount less. But if it had achieved revenue more quickly then grown much faster, that could make up the difference. In practice, we seem to be able to make these tradeoffs for most startups we encounter.

Importantly, we distinguish between the “market” price and the price we are willing to pay. While we may determine that the market price for a startup is X, that price is based on the startup going through the much lengthier, haphazard, and opaque process other investors use. So we typically ask for a price that is 20-30% below market. Conversely, we acknowledge that startups can likely get a 20-30% higher price if they are willing to go through that longer haphazard process. Note that this position makes us a more competitive choice for startups that don’t have a lead investor or a substantial fraction of the round closed. Startups that already have a chunk of working capital coming in obviously don’t get as much benefit from us moving quickly.

Logical Process

These two innovations, sticking to an ideal profile and aligning valuation expectations up front, lead to a straightforward, efficient investment process. We simply apply the concept of failing as fast as possible.

1. Receive request. We funnel all funding requests through our Web site to ensure we get a relatively consistent set of information that we can process quickly. Sometimes, we receive an electronic or verbal inquiry where we can “look ahead” to identify an obvious mismatch and save a founder the trouble of going to the site.
2. Screen for profile fit. Based on a company’s description, Web site, and deck, we try to determine if a company fits our ideal profile. Occasionally, making this determination may require a few emails.
3. Screen for valuation fit. Based on a company’s revenue model, current revenue level (including firm contracts going active soon), and capitalization structure, we calculate our valuation tolerance. Sometimes, making this determination may require a few emails. 
4. Make an estimated offer. If a company’s valuation expectations are far outside our tolerance, we often reject the deal out of hand. If there’s potentially some room for overlap, we will provide our estimated offer to the company. Sometimes, exploring whether there is overlap may require a few emails.
5. Review initial diligence documents. If there’s a profile fit and valuation alignment, we’ll review an initial set of diligence documents. We usually want to see a capitalization table, current balance sheet, monthly P&L spreadsheet, and some breakdown of customers.
6. Phone call. If the documents don’t present any red flags, we schedule a phone call to review the business in general and dig down on specific issues. Often we proactively schedule a phone call for a few days after the company’s estimated date for delivering the documents.
7. Make confirmed offer. Within 2 business days of the phone call, we make a confirmed offer or final rejection. We almost always make our offer based on a YC post-money SAFE with a cap set to our pre-money valuation plus the round size and a discount of 20%. In cases where there is a specific reason to use a different type of instrument, we can be flexible.
8. Final diligence. If the company accepts our offer, we proceed to final diligence. Unlike some investors, final diligence is not about figuring out whether there’s a good fit. Rather, it’s about verifying the information previously provided, as well as generally making sure the company is legally and financially squared away.
9. Execute investment. Once final diligence is complete, we generate investment documents, execute them, and then wire.

Typically, steps 1-4 take hours to days. The whole process requires 3-4 weeks from first contact to wire–if the company is responsive, has the necessary documents at hand, and there are no scheduling issues. 2 weeks is sometimes possible. The most common causes of delays are the company not having all the necessary initial and final diligence documents or there being some sort of circumstance that needs correction before we can proceed, such as converting to a C corporation. 

We often see other investors taking 3-4 months, sometimes longer, even in the good case. Moreover, we often see those investors saying, “No,” several months in. 

Internally, because our process always has a well-defined next step with a well-defined decision making scope, we rarely find ourselves getting bogged down. If we do, or if we end up having to say, “No,” late, we try to identify the underlying cause and fix it if possible.

Given this approach, we’ve found that it helps for founders to keep the following in mind:

• Meetings are late in our process. Just because we don’t take a meeting early, doesn’t mean we’re not seriously evaluating an opportunity. Scheduling introduces calendar delays and limits the number of startups we can work with at any one time. Luckily, we can collect the vast majority of information we need for a decision without a meeting. When we take a meeting (usually by Zoom), you have already checked off many of our boxes and we have concluded a fit is likely. 
• We care about the details of your revenues and unit economics. Because revenue is our number one metric, we tend to dig pretty deeply into the details of each revenue stream and its associated economics. We’re essentially trying to build a model of how your business generates gross margin.
• We care less directly about your vision and team. Other investors will often spend a lot of time trying to assess your vision and entrepreneurial spirit over several meetings. While we do care about vision and team, we are humble about our ability to assess them just by talking to you, so let the early results mostly speak for themselves.
• The more organized you are, the faster the process will go. However, we are patient. If, for whatever reason, you don’t have everything nicely organized, it usually won’t stop the deal. With a well-defined process, we can hold an investment at any stage while issues get resolved. In fact, we often help companies overcome obstacles during the process. But we would sincerely prefer to complete the process as quickly as possible so founders can start putting our investment to work in their businesses!
• We care about speed. We want to be fast so you can be fast. First, we want to get you back to the business of building your business. Then, once we’ve invested, we want you to have the resources for faster sales, marketing, and future fundraising.

In general, we see ourselves as less judgemental and more process driven than other investors. The goal is not to holistically assess each company and pronounce it a “good deal” or not. Rather, the goal is to systematically build a large portfolio of companies in a very specific area of the market. Just because a company isn’t in our target area doesn’t mean we don’t think it will succeed.

This post is by John Eng, RSCM's Director of Funding Ecosystem. He stays in constant contact with other investors so that we can effectively advise our portfolio companies on their subsequent rounds.

How has the recent tech downturn affected early stage VCs investment? Undoubtedly, all startups are asking themselves this question. Should they go for the seed or Series A round now or should they buckle down and raise a smaller round from existing investors? Our poll of Seed and Series A VCs reveals that these stages remain relatively robust, though tempered by more historically realistic expectations.

As I’m writing this, VC Twitter is foreshadowing doom and gloom. Is a recession imminent? Does it feel more like the dotcom bubble of 2000 or the housing bubble of 2008? Some big high-flying growth stocks have dropped by 75% to 90%. Public SaaS multiples dropped from a high of 17x to a low of 5.6x. When will we see tech stocks bottom? What’s the right valuation to pay for growth?

Based on VC Twitter, it sure seems like the sky is falling. Many well-known later-stage and growth-stage VCs have published “crucible-moment memos” about operating during a downturn–extending runway, get to default alive, get to default investable, expect valuations to come down, etc.

But what about early-stage companies? At Right Side Capital Management, we invest at the earliest stages. Our portfolio companies are typically concerned more about the early-stage investment climate, rather than later-stages that feel a more direct impact from public market turmoil. 

Can startups still get Seed or Series A investments? Well, we tried to answer this question. We conducted an informal survey of Seed and Series A investors the week of May 21 2022. Roughly 70 responded. We asked questions like:

• Are you still investing in new portfolio companies? If so, is your rate of investment higher, lower, or the same as it was prior to the recent tech downturn?
• Have there been any changes in your investment themes / strategy that I should be aware of? For example, are there any new sectors you are focusing on or avoiding, or have there been any changes to the traction levels you are looking for at different stages (ie. Seed, Series A, etc.)?
• Are there any other ways the recent downturn has affected your investing?

The results didn’t surprise us. The sky does not appear to be falling (at least yet) in early stage fundraising.

Key takeaways:

• Early stage investors are still very active. Everyone responded that they are indeed still investing and busier than ever. Some (20%) are more cautious and are slowing down their pace of investment. And a few (6%) are opportunistically increasing their pace of investment.
• Not many have changed their investment criteria. Those that have are just moving to earlier stages (i.e., to seed from Series A) and moving away from cyclical businesses.
• The bar is higher now. Investors are being more selective–a higher bar in terms of both revenue and unit economics. Investors are taking more time for due diligence now that deals are less competitive, digging more into business fundamentals before committing. They are asking companies how their businesses will be impacted by an economic downturn–growing inflation, higher interest rates, slowing consumer demand.
• Early stage investors are expecting lower valuations in Seed and Series A and are excited by it. They are already seeing a slow-down and lower valuations in Series A. They anticipate the same for seed-stage fundraising before long. Many investors who have been passing on high valuation deals are anticipating a faster pace of investment as valuations normalize. Some startups seeking Series A rounds may end up being disappointed in the valuations they receive (or don’t receive) and will need to raise bridge rounds to stay funded.
• Reserving more capital for follow-ons. They expect bridge rounds to become more common and are therefore shifting their allocation to accommodate that need within their existing portfolio companies. That means less capital available for new investments, which has to mean either less Seed and Series A rounds get done or that round sizes are smaller (or both).
• Spending more time advising their portcos. Startups that used to go 12 to 18 months between rounds are now expected to go 18 to 24 months before their next funding round.  As a result, investors are more engaged than normal with their portfolio companies helping them plan and adjust for this new reality. Survival, runway extension, and optimizing for unit economics is now the primary focus for most existing portfolio companies.

We understand that the changes at later stages should eventually trickle its way to earlier-stages. Some say it might happen in a month or two. Some say it might take longer.. However, the good news is that, for now, the early stage funding environment is still alive and open for business. VCs still want to meet founders. They still want to invest. The bar is higher. Valuations are lower. Due diligence is stricter. The Seed and Series A markets are not dead, they have just quickly reverted to what used to be considered normal conditions. This means early stage founders will need to adjust and become more realistic. 

We will continue to keep our eyes and ears open. I’d welcome your comments and news.

Since publishing Minimum Viable Investor Updates almost three years ago, I’ve processed thousands more updates. We finally hired someone to take over this task a few months ago and, as part of the knowledge transfer process, I’ve been thinking a lot about how startups could improve their updates.I’ve come up with a list of Dos and Don’ts that you can apply to your current updates, whether you’re using our minimum viable format or not. Consider it the distilled wisdom of someone who has likely processed more startup updates than any other investment principal on the planet.Getting It Done

• Do Start Small. A lot of founders, riding a wave of initial enthusiasm, start off writing huge, detailed missives… for a couple of months. But few can keep up that pace while running a high growth business. Then, in their own minds, they’ve set the bar too high and struggle to meet those self-imposed expectations. Better to start with a small, core update. Build the habit. Add to it incrementally. Same advice as for starting an exercise program if you want to get long-term results.
• Don’t Let the Perfect Be the Enemy of Adequate. Founders tend to be goal oriented, and those goals tend to be big. Many seem to have a vision of the perfect update in their minds--capturing all the excitement, possibility, and heartache they’re experiencing. That’s a lot of pressure to put on yourself every month while staring at a blank page. Especially with all the other demands on your time. Let yourself off the hook and and come up with a very basic template you can fill out in 10-20 minutes (see the Minimum Viable Investor Updates post for ideas).
• Don’t Fall into a “Shame Spiral”. Often, it seems founders miss an update, then feel like the next one has to be even better. Which makes the chance of delivering it lower. Which means the next one has to make up for two missed updates. And so on. Again, let yourself off the hook. Offer a brief apology, go back to Step 1, and Start Small.

Getting It Read

• Do Send as Email. Email is the least common denominator. All investors have it. Nearly all investors have evolved a system for organizing email that works for them. There are lots of tools for managing email lists. Don’t use Google Groups. Don’t use Slack. Don’t try completely new platforms like Telegram. Feel free to use other platforms in addition to email. But put your core updates in email. (Yes, I can provide detailed reasons why each alternative platform is inferior but they all essentially boil down to standard least common denominator platform arguments.)
• Don’t Put the Content in an Attachment. Honestly, I don’t understand why founders attach updates as PDF, Word, and PowerPoint. Sure, supplementary material is fine in those formats. But we receive a lot of updates where the founder has clearly written a specific update document and attached it as a file. Forcing the opening of a file just introduces friction and attachments break/slow some forms of searching. One founder said he felt it was more secure. As a former security guy, “Uh, no.” Note: there is an exception here. If the choice is between not sending a useful update at all and sending a pre-existing file like a Board deck or pitch deck traction slides, go ahead and send the file.
• Don’t Rely Solely an Online Service Like Reportedly. Anything that requires a logon introduces friction. But it also causes particular problems where partners in a firm jointly help portfolio companies and/or have a process for actively synthesizing a view of each portfolio company’s state. You don’t want a process that makes it hard for multiple people at a firm to look out for you. If you really want to use something like Reportedly, perhaps to manage discussions, copy the body of the update into the email as well. Note: if you want to centralize your detailed financial reporting as part of your accounting system, that’s fine. Just link to it from your update emails.

Maximizing Usefulness

• Do Put Metrics Up Front. Most founders seem to think the metrics are the punchline, but they should be the preamble. First, for the same psychological reasons that you want to put your traction up front in a pitch deck, as I explained in Your Pitch Deck is Wrong. Second, purely from a practical standpoint, if an investor is short on time, the metrics give the most information. Third, the metrics provide useful context for absorbing all the other information. Traffic shot up? I’m looking forward to finding out why. Burn spiked? I’ll expect an explanation. CAC and LTV both went up? This should be interesting.
• Do Include Financial Metrics. Financial metrics are your startup’s basic vital signs, like pulse and blood pressure. It’s really hard to maintain situational awareness of how things are going without them. Always provide Net Burn and Ending Cash. If you’re generating revenues, provide revenues. Better yet, break it down as applicable: recurring vs one time; COGs vs margin, inbound vs outbound, etc. Whatever is most relevant to your current situation. But please don’t use non-standard or ambiguous terms without defining them. If you’re not generating revenues, provide some indication of what the timeline is, whether it’s a target shipping date for revenue generating product, details of where prospective customers are in the pipeline, etc.Note: some founders think that financial metrics should be confidential. Not from people who gave you money! If there are people on your update list who are not investors and you don’t want them to know, split the distributions. If this sounds like a hassle, go to Step 1 and Start Small.
• Never Just Provide a Percentage Change. Perhaps even more frustrating than no financial metrics at all is seeing just a percentage change. Again, the motivation here seems to be confidentiality, but my same response applies. Statements like, “User acquisition costs dropped by 30% last month,” or, “Revenue rose 30% last month” are not only useless to your investors, they are extremely frustrating. The goal of your update is probably not to frustrate your investors.
• Do Provide Values as Well as Graphs. Graphs are great! But often the graphs will have weird scales or multiple scales or be generally hard to read. So if you graph a quantity, be sure that each point is either clearly labeled with the corresponding value or also put the values for the most recent period in text below the graph.
• Do Provide Fundraising Details. Investors can often help with fundraising. If not this round, then maybe the next one. We also like to get validation that our previous investment is appreciating! So knowing exactly where you are in a raise or where you ended up at close is important. If you’re raising, report the target amount, the target/hoped for valuation (range is fine), how much you have committed, how much closed, and from whom. If you’ve completed a raise, report final total, final terms, and final participants. And again, don’t use non-standard or ambiguous terms like, “We secured $500K from [firm].” What does that mean? A verbal promise, a written commitment, signed investment documents, a check?
• Do Organize Content into Digestible Chunks. Paragraphs of unbroken prose or lists of unbroken bullet points are hard to digest. Use descriptive and logical headings to group related information together. Never have more than three consecutive paragraphs of prose--and only then if the paraphs are reasonably short. Never have more than seven consecutive bullet points. Only have more than three consecutive graphs if they’re all closely related and seeing them together is necessary to provide a coherent picture.For reference, here are the sections we use in our internal app for summarizing company updates:- Metrics- Fundraising- Team- Business Model- Product/Engineering- Customers/Sales/Channel- Miscellaneous

Of course, you may have specific circumstances not addressed by this list. In general, it helps to have a model of what you’re investors are looking to get out of the updates. First, remember that they are looking at your company mostly from the outside and can’t possibly have all the context you have. And there’s no way you can load it into their heads in a reasonable period of time.Second, investors want to be helpful if possible. But you don’t necessarily know if you need help or the best way each investor could help. Experienced investors actually have more context than you on how startups in general develop and the challenges they encounter. They obviously have more context about their own capabilities. So the best path is to give them a high level and reasonably transparent view that both maintains consistency over time but also notes “inflection points” when you think you hit them.And you should always feel free to ask investors what they’re looking for.However, the absolutely most important thing is to send out an update regularly. Your investors and their extended networks are a valuable asset--but only if they are up-to-date on your company. If you have 6 investors, and they each give you just a single strategic introduction every other year, that’s 3 extra opportunities per year for good things to happen. You could be missing out on introductions to acquirers, channel partners, next round funders, experienced potential hires, relevant advice, and much more. All because your investors don’t know what’s going on with your business. Can you really afford not to put this free upside in play?

Have you ever finished an arduous task and thought to yourself, "Argh! I went about that all wrong. Why didn't anyone warn me?" Well, if you're thinking about raising a seed round, here's me warning you :-)When faced with a challenge, most entrepreneurs seek out as much data as possible, then wade in and start trying to make things happen. For fundraising, that probably means poring over TechCrunch, listening to as many "founder stories" as possible, and dissecting the top VCs' blogs.Of course, every one of these channels suffers from massive selection bias--only unusual events are noteworthy enough to make it through their filters. And fundraising is one of those processes where, if you optimize for the unusual case, you hurt yourself in the typical case.At RSCM, we've either observed our portfolio companies raise or directly participated in 100s of seed rounds over the last 4.5 years. We are intimately familiar with the typical case and have developed a corresponding "small seed playbook". And, should you be lucky enough to find yourself in the right tail of the fundraising curve, there's any easy upgrade path.

Too Much Money, Obsession with a "Lead"

The most common mistakes in raising a seed round are: a headline amount that's too large and getting anchored on the concept of a "lead" investor.Raising seed is rarely easy. But there's a very steep gradient in difficulty as you move from a $500K to $1M target. In that range, you usually need substantial revenues, a clearly pedigreed team, or anti-gravity class technology. Sure, there's some chance you could find investors who simply fall in love with you and your idea (most likely if you're in the SF Bay Area or NYC), but the probability is low and the expected search effort is high.Even if you satisfy one or more of the extreme requirements, as you get towards $1M, a lead investor becomes more and more necessary. Now, you may be thinking to yourself, "That's OK; I want a lead!" Hmmm. If you're an engineer, what would you think if someone said, "I want an architecture with a single point of failure!" Or in marketing, "I want a campaign targeted at users with low conversion rates!" Or in sales, "I want prospects with long sales cycles!" Yes, there are cases where that is in fact what you want, because there are other factors that balance out the obvious drawbacks. But as a rule of thumb, it's a mistake.Suppose you plan your round around a lead from the outset. If you don't end up finding one, you have precisely zero dollars to show for your efforts. Moreover, the universe of lead investors is much smaller than that of all investors, so the prospecting job is correspondingly much harder. Finally, it typically takes a lot longer to get a first serious meeting with a potential lead investor, let alone close the deal. You're probably in for a much longer fundraising cycle, which has tremendous opportunity cost in terms of building your business, especially at the seed stage.Unless you truly meet some of the aforementioned extreme criteria, this path is probably not optimal. Our recommendation is that you don't start a seed raise by looking for a lead unless you have at least $20K in monthly revenues, a dozen professional investors who have proactively expressed interest, or your business simply cannot move forward without a large chunk of capital.

Modest Raise, Brick-by-Brick, Graduated Price

So what do you do if you have zero to small revenues and don't have a lot of VCs on speed dial? Start with a modest headline amount, $250K to $500K. Your plan will have to show you making decent progress with this amount of money. Make sure your development schedule and cash burn support you hitting a reasonable milestone with that much runway. And be prepared to tighten your belt; fundraising almost always takes longer than expected.Then get your first commitments from your most enthusiastic supporters and members of their immediate networks. Usually, when I ask a company who is planning or trying to raise if they have anybody close to the company (friends and family, advisor, early customer, etc.) who could write a small check, the answer is yes. When I ask them why they haven't tried to close the money yet, the answer is usually some combination of, "It doesn't really move the needle," and "We don't know what terms to use."At the very beginning of a raise, pretty much no check is too small. You need to get the ball rolling. You also need to show momentum. So use attractive terms that lead to a quick close. I recommend a convertible note with the standard 20% discount and 5% interest, plus a very compelling cap. If you have an attractive valuation, people will not mind so much that you don't have a lead investor. The plan is to start the cap low and raise it gradually as you build momentum.Now, a lot of founders worry about dilution and lose sleep over getting "fair" value. Don't. $100-200K worth of dilution at a valuation even 30 or 40% below what you think is market just won't make very much difference in the long run--I assure you that there are much worse dilution potholes on the road to liquidity. And fundraising is a terrible distraction from operating your business, so an investor willing to move quickly is valuable.You must make clear that you're offering the earliest investors the great deal partly in return for moving quickly (the other part is due to the special relationship and/or value-add of the investor). Otherwise, most investors will dither. Sometimes it helps to tie the great deal to some sort of natural deadline like an accelerator Demo Day, a significant software release, or a large customer close. Creating a sense of urgency is much easier said than done, but you need to try.Somewhere after $100-200K, you bump the cap up. "The great deal" becomes "the good deal". The size of the bump depends on what the market tells you. If you closed the first chunk really fast and you have a big pipeline of prospects, bump the cap two notches. If the first chunk was still a fair bit of work or your pipeline seems thin, only bump it one notch. But keep the time pressure on to the extent you can. "The good deal" is also a limited time offer, perhaps tied to yet another natural deadline.Once you have the first two chunks in, you can start to play a little more strategically. Getting half the the round closed often generates psychological momentum. You'll also have money in the bank, which helps your negotiating position. And you'll hopefully have made further engineering and customer progress, which makes you less risky. You can bump the cap again. You can also start trying to work AngelList and look to bigger geographies like San Francisco or NYC (if you're not based there already). You can event start seriously probing small funds who lead rounds. This is where the upgrade path comes in.

Sidebar: Process Is Key

Before I get to upgrading a small seed round to a big seed round, I need to make a point about process. Like achieving any other company objective, fundraising works better if you impose some structure on it. You absolutely must track prospects, either in a spreadsheet or a CRM.I recommend a couple of prospect categories: first checks, second checks, later checks, and round leads. Initially, focus on developing lists for the first two categories. You will also naturally generate names of people within your network that fall into the second two categories, but don't devote too much energy to extending those lists until you're ready to actively pursue those categories.Now, start talking with all the first check prospects, focusing on two initial objectives. First, qualify each prospect. There are three basic qualification states: (1) does in fact appear to be a potential first check writer, (2) doesn't appear to be a first check writer but may be a second or later check writer, or (3) doesn't appear to be a check writer at all.Second, try to expand you lists through the prospects' networks. Ask class (1) prospects if they know anyone else who is as decisive as they are or investors that tend to follow their lead. Ask class (2) prospects if there's anyone who they like to follow or people they typically participate alongside. In my experience, members of class (3) rarely make good referrals.After you work through the first check prospects, move on to the second check ones, with parallel qualification and list expansion objectives.If you have time during the first check and second check prospecting, do some modest scouting of the later check and round lead prospects. Go ahead and schedule some first meetings. These prospects probably have long scheduling lead times and require multiple stage-setting meetings anyway. The goal here is not to close them (though if they fall in your lap, seize the opportunity). Rather, the goal is gather intelligence on what they're looking for and start building a relationship. Try to keep detailed notes in whatever tracking system you use.

Oversubscribe, Entertain a Lead, Convert if Necessary

OK, back to upgrading. Please keep in mind this is no longer the base case. Most no-to-low revenue startups never get to this point.Suppose first-check demand justified a two notch bump in your cap, second-check demand seems strong even at the higher price, and later-check and lead scouting has yielded a promising pipeline. Further suppose that you've made good operational progress in the meantime. If all these stars align, you can attempt the upgrade.In this everything-goes-smoothly scenario, you should be having lots of positive meetings with later-check prospects. At some point, it may look like you've got more "soft-commits" from later-check writers than you have room (assuming you stick to your original target amount). Or you may receive strong buying signals from some of your lead prospects. If either of these conditions are true, do one of two things:

1. Force a quick close and oversubscribe if desired. Tell all interested investors that it looks like you might be oversubscribed. Make it clear that you need to get firm commitments so you can figure out if there is any room left. In other words, use scarcity and social proof to get investors to move. You can then decide whether you want to raise a larger amount than your original target.
2. Move to close any viable professional funds as "leads". The term “lead investor” is confusing. You naturally assume they come first. In $1M+ rounds they usually do, but in seed rounds they often just take everything left at the end. A situation that often arises is you're talking to a potential “lead” investor that only writes $250K+ checks, but moves very slowly. At the same time, you have several later check writers that you feel you can pretty quickly and you probably don’t have room for everyone. In this situation, you need to force the action with the potential lead investor. Give them a deadline and tell them you need a term sheet in 7-10 days or you will close your existing pipeline. Absolutely do not risk losing other investors because you want to hold out for the "lead". When you are a low revenue company, always take the bird in the hand.

The goal in both cases, obviously, is to create a sense of both scarcity and urgency. As a low revenue startup you rarely have leverage when fundraising. Anytime you do find some, use itMost institutional investors these days are comfortable leading a seed round with a convertible note structure. There are still a few that have a strong preference for priced rounds. If you run into one that insists on a preferred equity financing and you’ve already close a bunch of investors on notes, don’t sweat it. You can always convert all the other notes into the preferred round.

Parting Wisdom

Remember, it's usually pretty easy to adjust and pivot when things go better than expected. So you don't need to plan much for those scenarios. This playbook is targeted at the usual case. Oversubscribed and led seed rounds are the exception rather than rule.Depending on market conditions, I would say only 10-20% of seed rounds are "led" in any meaningful sense and another 10-20% are oversubscribed from a modest original target. So 60-80% are just ordinary, every day seed rounds that take a while to close and have no real lead investor. Which is totally fine. Fundraising is really hard. $250K to $500K is a win. That's roughly a year of runway and I'm continually blown away at what entrepreneurs manage to accomplish in a year.

I see a lot of pitch decks. Hundreds per year. Almost every one is wrong. Not the startup idea. Not the slide layout. Not the facts per se. But which facts and in what order. Nearly all founders use a structure guaranteed to kill their “conversion rate”.

The common flaw stems from a fundamental mismatch in the way our brains create versus consume content. Each engages a different forms of reasoning. I studied this general topic in graduate school under one of the pioneers in the field. I kept up with the literature over the years. And I observed a huge number of pitches. But it still took me years to realize what was happening (repeating the same mistake in my own pitches, of course). Once I did, I couldn’t help appreciating the ironic beauty of the situation.

First, some background in cognitive psychology. Your brain has two completely different reasoning systems. System 1 is the fast, associative pattern-matching module—good for sitting in the background while you walk the plains and then rapidly determining whether a rustle in the bushes signifies mortal danger or a tasty dinner. System 2 is the slow, logical alternative-weighing module—good for deliberately figuring out whether it’s best to make camp by the river or on the hill. (If you want the full general audience explanation of System 1 and System 2, read Thinking Fast and Slow by Daniel Khaneman, who was the partner of my late professor, Amos Tversky.)

Now, when you build a pitch deck, you have to call on System 2 to develop the content. System 2 is logical so you can’t help but try to construct a deductive proof of why someone should invest in your company. That’s why most pitches have 3-7 slides setting the stage: here’s the problem, here’s the size of the problem, here are the current solutions, here are the drawbacks of current solutions, here are the requirements for a better solution…” I refer to this pattern as “In the Beginning”.

However, when investors consume that pitch deck, either at Demo Day, in an email, or face-to-face, they call on System 1. For most people in most situations, System 1 is the default. System 2 takes much more energy and operates much more slowly, so it only gets called on when something special happens. Thus, unless your pitch quickly triggers investors' System 1s to recognize your company as a tasty dinner, their System 2s will never wake up and no amount of logic can help you. And then when you use your System 2 to try and improve your pitch, you'll be blind to the problem.

You may be wondering why none of your advisers notice this problem when they reviewed your deck or watched a practice pitch? Here's another ironic bit. People who sincerely want to help with your pitch will expend the effort to use System 2, also blinding them to the lack of System 1 appeal.

Perhaps the worst case of “In the Beginning” I’ve seen was at a pitch event several years ago with a brutal schedule of 12 fifteen-minute slots. A company in the last hour really started at the beginning: the last generation of technology, quotes on recent shortcomings of that generation, market sizing for the next generation, the founders’ previous experience designing this type of system, technical architecture of their new solution, and performance metrics versus the primary incumbent. Logical, but not engaging. Ran over his time and had to rush through the last slide, which was something along the lines of logos for 5 blue chip enterprise customers, an average annual contract value of $60K/year, and current $MRR of $35K/month with 20% MoM growth for 6 months.

WTF? By the time that slide flashed on the screen, 80% of the audience members were fiddling with their cellphones or chatting with their neighbors. Talk about a missed opportunity! Better to just show that last slide, drop the mike, and walk off the stage!

Luckily, identifying the problem suggests an obvious solution—focus on triggering System 1 to flag you as interesting. So without further ado, here’s Kevin’s “Hey, tasty dinner right here!” pitch template:

• ^‍Title Slide
• Context Slide: super high-level explanation of what you do, 5 bullets max
• BOOM! Slide: the most impressive thing about your company
• Ask Slide: what the next BOOM will be and what you need to get there‍
• Why Slides: details on how you made the first boom happen and why you’ll make the next boom happen too

Putting the Ask right after the Boom is key. The Boom triggers alertness and primes for action. Then you’ve got to give the investors something to pursue. Otherwise, you may lose their interest. Also, telling them about good stuff that will happen in the future right after good stuff that has already happened in the past naturally gives your good-stuff-forecast more credibility. Your investment ask will seem maximally reasonable at this point.

You may wonder why you need the Why slides at all? Well, once you wake up System 2, it needs to eat too. But keep the Why section as small as possible. The more facts you present, the more chance that System 2 will find a strong objection and dismiss you so it can go back to sleep—remember, System 2 requires a lot of energy. The goal is to just satisfy System 2 and get to the next step in the process. where you can bring other cognitive mechanisms into action. Oh, and when delivering the Why, keep referring back to the Boom as much as possible to maintain alertness. For example: “[Supporting Evidence]… which is why X customer loves us so much and is paying us so much money.”

My guess is that most founders’ pitch decks already contains 80%+ of this content. It’s just in the wrong order and probably too much detail on Context and Why. The big question you probably have is, “What should my Boom be?” Sorry, no blanket advice here. It’s situation dependent. But guess what? By simplifying the problem to one question, we’ve made it amenable to A/B testing. If your Boom isn’t obvious, generate 3-7 alternatives and test them against several investors each. Also, if you can’t come up with a decent Boom, it might be a signal that you haven’t made enough progress to fundraise with much success. So your near term goal becomes to make something Boom-worthy happen.

That's my preliminary diagnosis and treatment. I’ve given this advice face-to-face to many startups over the past two years and have received a lot of positive feedback. But it’s an inherently limited sample. So if you read this post, try out the approach, and learn anything interesting (positive or negative), please drop me a line and let me know! Maybe someday we'll be able to develop a thoroughly researched system of Evidence Based Pitching (EBP).

Regular readers know that I've been trying to bust the "Seed Bubble" myth for years. In my latest analysis, I show that total seed funding in 2014 was nearly identical to that in 2008, not even adjusting for inflation or economic growth. Over the last year, I've encountered several other persistent VC myths that similarly conflict with the data. Given that the seed bubble meme seems to be subsiding (though I dispute talk of a nonexistent bubble "popping"), I thought I'd tilt at some of these other windmills.

Myth 1: Series A Crunch

The easiest target is the myth of the "Series A Crunch". As far as I can tell, the first mention of this hypothesis was in a November 2011 blog post by Elad Gil. After a year of bouncing around the echo chamber, this November 2012 Pando Daily article by Sarah Lacy was pretty typical: "Everyone -- to a person -- says it's a real phenomenon...That means we're getting a very different 'nuclear winter' as a result of industry excesses this time around."OK, so let's look at the data on Early Stage VC dollars and deals from the NVCA.

Hmm. I'm having trouble seeing much of a "crunch".  Pretty much up and to the right since 2009. Perhaps a slight valuation correction from 2011 to 2012, but deal volume was still going up. Certainly not a "nuclear winter".  Basic version of the myth.. busted.

Myth 2: Seed - Series A Imbalance

But there's a variant of the Series A Crunch argument that the real problem is a Seed - Series A Imbalance. It's not the absolute amount of Series A activity, rather there's an overhang of increased Seed activity that is/will be causing a shortage of Series A down the line. Both the aforementioned Gil and Lacy pieces presage this twist. But this March 2015 Fortune article says it all in the title, "Free-flowing seed capital is giving startup founders a false sense of confidence," and subtitle, "And it’s causing chaos ahead of the Series A round."

Now, if you've read my Seed Bubble posts, you know that seed capital has not been "free flowing" over the past few years.  But even I was shocked at the stark reality when I overlay VC Early and All Seed funding on the same graph.

For a long time, seed funding was much greater than VC Early funding--twice the size or more. Then VC Early started to creep up. During the period of the supposed "Series A Crunch", VC Early funding was actually shooting up from about 10% less to 60% more than All Seed. In fact, the ratio of VC Early to Seed tied the all time high in 2011 when the crunch supposedly began, then nearly doubled that record by 2014. If there's an imbalance by historical standards, it's the opposite direction!

Myth 3: "I'm Allocated to Seed"

Obviously, if people managing investment portfolios believe the Series A Crunch or Seed - Series A Imbalance myths, they won't allocate dollars across startup stages correctly. This trap is compounded by a misimpression of the stages themselves. Many investors believe they are allocated to "seed" when in fact they have only fractional exposure to "something VCs call seed but is vastly different from the rest of the seed market." From an allocation perspective, misidentifying your asset classes is a huge danger.

In my opinion, what VCs call seed is not the same as the rest of the market. Just look at the average size of a VC deal vs the average size of an angel deal. (Note that the angel number is the average size of at all stages so the graph actually understates the difference at the seed stage; unfortunately, CVR tracks angel deal volume, but not deal size, by stage.)

The ratio rose from about 4X in 2002 to 11.5X in 2014, with a peak of 14.5X in 2009. There's clearly a categorical difference between what VCs and angels call seed.

Moreover, if you invest in an early stage VC fund, at best a modest fraction of each dollar actually goes to seed. Most early stage VCs make only a small subset of their initial investments at the round they call seed (unsurprisingly, most of the money goes into the round they call "early"). Moreover, even funds who always make their initial investments at what they call seed generally reserve at least $1 of follow-on for each initial $1. So at absolute best, investors who think they have seed exposure through VCs are getting half their dollars exposed to only the tiny slice of the seed market that accounts for the largest deals.

The share of this very high end of the market dropped precipitously in 2011.

In my opinion, the combination of all these factors means most investors in funds are dramatically under-allocated to over 90% of the seed stage technology startup market--a market that's roughly the same size as the Early Stage VC market.Does this difference matter?  Well, if you're worried about portfolio allocation to illiquid assets, you should be pretty concerned about the future liquidity options for such assets. From that perspective, here's a sobering statistic from CB Insights (secondary source because primary requires registration):

In 2014, 73% of technology companies acquired never took traditional VC.

So if you believe that that VC Seed gets you exposure to the entire seed stage startup asset class, your portfolio will lack exposure to 3/4 of the liquidity options. By the way, this statistic is up from 2/3 in 2013. And with record amounts of cash on the large technology company balance sheets that make these acquisitions, I could easily see this bias growing further. Imagine a portfolio that lacks exposure to 80% or 90% of the liquidity events in that asset class! This third party data dovetails nicely with my previous calculation of a massive difference in the small M&A vs IPO and large M&A market.

I will stipulate that the VC-backed exits are almost certainly each bigger. But the goal of portfolio allocation is to balance out risks within and across asset classes. The data makes it clear that relying on VC Seed leaves a portfolio exposed to idiosyncratic risks within a particularly narrow exit market. So finding some way to target the other 90% of the seed stage technology startup market seems like prudent portfolio construction.

Of course, there may be different data out there or I may have botched the crunching somehow.  So as always, feel free to check the work on my spreadsheet.

In my last post, I showed how taking a round of funding logically reduces the available exit options. As a rule of thumb, each round of funding reduces exit opportunities by 10X (assuming a default price-elasticity of 1). Now let's focus on the specifics of Series A.

If you just want the summary, there is a particularly large cliff at Series A: I estimate a 25X reduction. My guess is that the difference is due to early stage VCs wanting bigger multiples than late stage angels and potential acquirers becoming much more price sensitive in the affected valuation range.

Here's the detailed math... Traditional Series A VCs want $100M+ exits. (see here, here, and here). This target makes perfect sense when you work the numbers. Adding up the pre-money valuation and amount raised at Series A from Wilson Sonsini, we see that the  typical post-money valuation is currently on the order of $10M. Now, early stage VCs consider 10X returns to be a successful investment (reference here). Result: an exit on the order of $100M is the minimum.

Of course, if a company’s Series A investors become convinced they can’t achieve their minimum, they’ll accept less. But there are two issues with that scenario from the founder perspective. First, part of what VCs do when they make a Series A investment is help put the company on the operational path necessary to support a business worth $100M+, a path that requires burning cash. So by the time the investors admit they won’t hit their target, the company is often strapped and the exit options start heading towards “fire sale” valuations.

Second, VCs almost always have liquidation preferences, i.e., they get paid before the founders. The combination means failing to hit $100M often means the founders and employees don’t make out very well. Therefore, from the founder perspective, if you take a traditional Series A round, the prevalence of $100M+ VC-backed startup exits is a pretty important statistic.

This number is fairly straightforward to estimate. According to Ernst and Young, there were an average of 41 VC-backed IPOs per year from 2007 through 1H2012. For our purposes here, I assume all those were over $100M. According to to CB Insights, there were 111 private technology company acquisitions over $100M in 2012, thought not all of these would necessarily be VC-backed. This data jibes with the NVCA data on VC-backed companies with M&A exits at least as large as their total funding: 92 in 2012, 112 in 2011, and 85 in 2010. Not all of these would necessarily be over $100M, but we're just using this number as a quick double-check.

So given these datapoints, I think 200 is a very gracious rough estimate of the number of $100M+ VC-backed startup exits per year.Now, if we examine the NVCA data on "Early Stage" deals from 2001-2010, we see the average number per year of was almost exactly 1,000. So assuming a relatively steady state, a founder who accepts a traditional Series A round has about a 20% chance of seeing a substantial payout.

Consider the alternative. Run leaner. Try to just achieve initial product-market fit or a significant technological breakthrough. Get acquired by a large company for under $50M. The numbers here are harder to find. the CB Insights report covers this price range, but looks pretty inaccurate. For example, it says Google acquired 12 companies in 2012. But Google's 2012 SEC Form 10-K says it acquired 53 companies--that's less than 1/4 accounted for by CB Insights. Presumably, it is the smaller acquisitions they miss.

To achieve better accuracy, RSCM asked a friend with access to the S&P Capital IQ database to do a quick search for us on M&A deals under $50M from 2001 to 2010. Unfortunately, deal size wasn’t disclosed in many cases. We figured the unreported-size transactions were probably almost all under $50M, but conservatively assumed it was 90%.  

Given this assumptions, our estimate of the average was 5,000 per year. On the one hand, this estimate is for all private company transactions not just those in the technology sector. On the other hand, we used the number of Google acquisitions as a double check and found only about 2/3 of Google's acquisitions were in the database. So for the purposes of rough estimation, assuming these errors cancel seems reasonable.

Using the spreadsheet from my latest Seed Bubble post, we can estimate that about 22,000 companies per year receive seed stage angel funding. Remember that most of these companies fail before they reach the point at which they could even consider Series A funding. To be gracious, let's assume 50% make it to that stage. So that means that a company that forgoes a Series A has very approximately a 5K/11K = 45% chance of seeing a payout via small acquisition.

Bottom line: if you know a founder received a substantial payout, the probability is about 25X higher that it came from a small exit than a large one. Prospectively, a founder that chooses to avoid Series A is about 2.5X more likely to achieve decent liquidity. Though if you do succeed going the Series A route, the amount of liquidity will likely be much higher.

Then there’s the “reputational effect”. Getting a successful exit under your belt is a huge benefit in terms of how people perceive you in the startup world. So first-time entrepreneurs should be particularly biased towards higher probability exit options. Especially because even a modest payout helps fund the next startup (where you can hold out for that traditional Series A if that's your long term goal).

Taking these factors into account, a first-time entrepreneur may actually lower the total future expected value of his or her entrepreneurial endeavors by accepting a traditional Series A round. Again, I’m not saying that this path is always wrong. But it’s wrong a lot more often than most entrepreneurs think.

Also, I’m not recommending that most entrepreneurs swear off Series A unconditionally. Rather, I’m recommending that most entrepreneurs keep their options open by taking smaller seed rounds and extra angel rounds. Have enough certainty about the technology and business to know what your acquisition price would be before you decide that the traditional VC route is the best alternative. There will be exceptions, of course. An opportunity may be so big and emerging so quickly that even a first time entrepreneur should absolutely take Series A as early as possible. But those situation will be rare.

For what it's worth. Your mileage may vary. Standard disclaimers apply.

[Update 5/7/2015: Don't just take my word for it. Bhavin Parikh, founder of Magoosh, weighs in, supporting these cautions about taking a Series A.][Update 2/22/2015: I looked up the current numbers from E&Y and CB Insights. Short answer is that activity was up a little in 2013 and 2014. According to E&Y, US-based VC-backed IPOs were 67 in 2012 and 74 in 2013, higher than the 2007-2011 average of 41. According to CB Insights, the total for US-based Tech exits over $100M was 144 in 2013 and 217 in 2014. Subtracting out their IPO numbers gives us US-based Tech M&A of 80 in 2013 and 138 in 2014. So 200 still looks like a very good long term estimate of the number of US-based VC-backed exits over $100M.  Especially because the detailed 2014 report says that 73% of all exits are for companies that never raised VC or PE dollars. Note that Early Stage VC activity is up to ~2,000 per year in 2013 and 2014. So the odds may have actually gone down.]

I have posted quite a bit of analysis that is (hopefully) useful to startup investors. But as someone noted to me privately, I have not provided much direct advice for startup founders. This post is a first step toward reducing the imbalance.Face-to-face, the number one tip I give to founders is: think very carefully before taking any round of funding. No, not because of dilution. Because funding closes off exit opportunities. "What?" you say, "But an investment will give me the resources to make my company more attractive for an exit."That's true, but it will also raise your asking price... by a lot! And as basic economics tells us, demand drops with price. In this case, it drops a lot! I'll actually work through the detailed math and data for Series A in my next post. But here I want to make the more general point.Remember that investors want a return. They have mental anchor points for exits they consider a "win". This anchor typically varies from 5X to 10X. Professional investors usually get legal stock preferences that allow them to block exits that they don't like, i.e., that are out of line with their anchors. Now, they also have mental anchor points for how much of the company they want to buy in the round. This anchor typically varies from 20% to 30%.Let's consider the midpoints of those two anchors, 7.5X and 25% to do a quick estimation of how taking a round of funding reduces exit opportunities. Say your company is worth Y today. If investors want to own 25% of your company, the post-money will be 1.33Y. If investors want a 7.5X return, the required exit price will be 10Y.

Every round of funding you take increases your required exit price by an order of magnitude!

So if you take an angel seed round at a $3M pre-money, you now need a $30M exit. Not too bad. Then a Series A at a $10M pre-money pushes that up to $100M. Pretty steep. Series B at $25M means $250M. Whoa. How many $250M exits happen per year? About 50 to 100. There are about 1,000 early stage VC investments per year. Not good odds.As we'll see in the next post, there's a huge cliff at Series A. But in general, the number of exit opportunities goes down exponentially with each round of funding. So consider whether an exponential reduction in the number of prospects is worth the progress you'll make.

In playing with the data from my previous angel diversification posts (here, here, and here), I developed the best visualization so far of how to improve your angel portfolio with more investments.  Simply compare the cumulative probabilities of achieving given return levels for different portfolio sizes using historical AIPP angel data.If this graph doesn't convince someone, I don't know what would:

This shows the marginal benefit of doubling your portfolio, starting at 25 investments.  At some point, your cumulative outcome probability drops off a cliff.  For 25 investments, the cliff is at 1x your money.  For 100 investments, the cliff is at 2x your money.  For 400 investments, the cliff is at 2.5x your money. (Yes, I admit to playing with the Y axis scale to dramatize the effect.)

At 800 investments, the cliff is all the way out at 3x your money.  You would have had a 95% chance of tripling your money!

Another way to think of it is that the area between any two lines is the cost of not diversifying your portfolio to that level.  Just look at the "wedge" between 25 and 200.  It's enormous.  Now who doesn't want to diversify?

The data analyses from my last two posts, How Many Angel Investments? and What If the Angel Market Tanks?, have an important alternative interpretation.  If you also read my earlier posts on diversification in general, Diversification Is a "Fact" and Even If You're "Good" Diversification Matters, you may have an inkling of what's coming.  The punchline is:

For angels, diversification can be more important than skill...

(... at the margin,  if all you care about is returns, and you have typical risk preferences.)

I know what some of you are thinking: "Oh, you're one of those crazy 'spray and pray' guys who don't think you need to learn anything about a company to invest in it.  Don't you know angel investing takes a lot of experience and time?"Before you write me off as a loon, please give me just a few more seconds of your time.  That's not actually what I'm saying.  There are some rather crucial nuances and disclaimers. Moreover, the analysis we've already done with the AIPP sample of actual angel investments clearly supports my nuanced and disclaimed position.First, let's reinterpret the "50% Complete Failure" scenario from the last post. Instead of looking at it as a possible future scenario for the angel market as a whole, let's look at it as the possible future outcome distribution for a slightly different investing strategy, "Scalable Angel".

This hypothetical strategy contrasts with the traditional investment strategy, "Custom Angel". Using the Custom Angel strategy, individual angels and angel groups apply their substantial experience to perform a lengthy personalized screening and evaluation of each startup investment opportunity.  While very thorough, this strategy is not very scalable. It requires years to develop the necessary skill and a considerable amount of time to apply.The Scalable Angel strategy is based on the Custom Angel strategy. However, it eliminates many screening and evaluation tasks that can't be boiled down to policies, templates, and heuristics.  It still applies a lot of screening and evaluation. It even applies a fair amount of personalized attention. It just avoids the lowest-value and most time-consuming steps. While definitely more scalable, a lot of people may find it hard to believe that it could be as effective.

So for the sake of argument, let's assume that it's not nearly as good as the Custom Angel strategy and results in 50% more failed investments. The "Baseline 40% Complete Failure" scenario from the last post had 111 failures, while the "50% Complete Failure" scenario had 166, which is 49.5% more. So, conveniently, we can use the resampling of 50% Complete Failure to represent the outcome distribution for the Scalable Angel strategy.

Now, all we have to do is decide on reasonable portfolio sizes to compare.  In the original Rob Wiltbank Tech Crunch article that kicked off this series of posts, he recommended "...at least a dozen investments...". To give Custom Angel the benefit of the doubt, let's use 15.  My anecdotal experience is that a 15-investment portfolio would put an angel in the "very active" category.  On the other end of the spectrum, RSCM (my firm) is aiming for 250 investments in its fund and, as Dave McClure so kindly contributed in the comments of the last post, 500 Startups will have about 250 investments per fund.  But let's again be conservative, so we'll use 200 investments for our hypothetical Scalable Angel strategy.

It's a simple mater to look at the last post's spreadsheet and plot the probabilities of achieving different return multiples using the two strategies:

Due to our assumption of a much higher number of failures, Scalable Angel has a lower expected value, 3.66x vs 3.24x.  But is sure looks a lot safer overall! Scalable Angel did not have a single losing portfolio out of 10,000 simulations while almost 8% of Custom Angel portfolios lost money.  Scalable Angel has a whopping 24 percentage point advantage in doubling your money (95.17% vs 70.98%).  Even at tripling your money, where its lower expected value starts becoming apparent, it has a 9 percentage point advantage (49.61% vs 58.32%).

What about those nuances and disclaimers? Well, Scalable Angel certainly does not assume we can costlessly eliminate screening and due diligence. It assumes we can either streamline or find streamlined substitutes for many, but not all, aspects of screening and due diligence.  For those we can't, it assumes we pay a pretty hefty penalty of 50% more complete failures.

Also, it assumes that angels are interested only in overall returns. Individual angels and angel groups may be legitimately concerned with the failure rate.  If part of why you like being an angel is the feeling you get from helping a company succeed, I would certainly understand wanting to maximize the number of successes even if that resulted in greater financial risk (especially if you were risking a very small fraction of your overall wealth). On the topic of risk, our conclusion further assumes angels are willing to sacrifice a bit of return on the high end for a much lower chance of  suffering outright losses or even under-performing the public equity market.  While individuals certainly differ, the empirical literature on risk preferences (nicely summarized here) supports this assumption for typical investors.

On the other hand, our current analysis also ignores some likely additional advantages of the Scalable Angel strategy. First, when you make a process more systematic, you usually reduce per unit costs. The AIPP data, indeed angels in general, do not track investment costs very precisely. My anecdotal experience is that a fair accounting of angel out-of-pocket and labor expenses would put them at a noticeable fraction of the dollars they invest. By ignoring these expenses, the AIPP data overstate the return of the Custom Angel strategy. Like any high-efficiency process, the Scalable Angel process would probably cut these costs dramatically, increasing its true relative return.

Moreover, high-volume processes tend to be more measurable than custom ones. Greater measurement leads to greater optimization. That's the point of the whole "Big Data" trend! So even if the Scalable Angel strategy were initially less effective, over time, I bet it would close the gap in the expected failure rate, probably eventually surpassing Custom Angel.

Finally, I don't think Scalable Angel would actually have a substantially worse outcome distribution. If you saw Moneyball, you know that some relatively simple metrics outperformed all those experienced baseball scouts performing their individual player evaluations.  In this old post, I present the strong empirical evidence against individual's ability to predict success when a startup launches.  Now, ongoing individual attention probably provides some  benefit to a startup's development.  But in practice, RSCM and 500 Startups provide quite a bit of this type of guidance.  If you performed a detailed comparison of this assistance vs the typical active angel's assistance, I think it would be hard to argue that the difference would lead to 50% more failures.

So I think it's pretty safe to say that our hypothetical Scalable Angel outcome distribution is an extremely conservative comparison to past practice.  And it still clearly outperforms in terms of risk-reward. From the perspective of angel investments as investments, the evidence strongly supports scalable approaches as a competitive option.

[Updated 4/25/2013: corrected minor error in spreadsheet and graph.]

In my last post, I showed how diversification helps an angel portfolio get closer to the true underlying return of the market.  Based on the AIPP's historical sample of angel-backed startups that meet RSCM's investment criteria, we saw that 70 investments would have given you a ~90% chance of doubling your money and 200 would have given you an ~80% chance of tripling your money.

Of course, almost everyone has heard the disclaimer, "Past performance is no guarantee of future results."  We don't really know that angel investments made today will have the same outcome distribution as those made in the past.  No amount of statistical wizardy can change that.  However, the resampling technique I used in the last post does reveal how a diversified portfolio can provide some protection against losses if the angel market tanks.

Let's call a "complete failure" an investment that loses more than 50% of the original capital.  Under that definition, the original sample has almost exactly a 40% failure rate: 111 out 277 investments.

So let's adjust our resampling procedure to simulate different rates of failure in the future.  By simply adding in extra copies of the 111 "completely failed" investments, we can see what happens with 50%, 60%, and 70% failure probabilities. Obviously, expected returns decrease as failures increase.  But what about the chance of overall loss?  Does diversification protect us?

First, let's refresh our memories with a graph of how different portfolio sizes fare under our baseline scenario of 40% complete failures.  Note, that I've extended the maximum portfolio size analyzed to 500.

To simulate a 50% failure rate in the future, we start with our baseline sample and add 55 duplicate records of complete failures to create a new sample with a somewhat worse outcome distribution.  That makes the failure rate (111+55) / (277+55) = .50. The expected payout is now 3.24x instead of 3.66x. Then we run the resampling procedure on the new sample.  The next graph shows the resulting probabilities of achieving 1x, 2x, and 3x the original investment.

Still not too bad.  We'd almost certainly double our money and have a decent chance of tripling.  What happens if the angel market really tanks?  By adding in more copies of complete failures, we can simulate 60% and 70% failure rates.  Expected payouts drop to 2.68x and1.97x, respectively.  The next graphs present the probabilities of 1x, 1.5X, and 2x outcomes for these scenarios.  3x is such a remote possibility, I've left it out and put in a 1.5X line to give us better resolution.

60% failures isn't too bad.  We can still drive the chance of doubling our money above 90% with 500 investments.  70% complete failures sucks.  Especially when you look at it from the perspective of homeruns. Remember that big winners drive returns.  If a "homerun" is any investment with at least a 10x return, adding in all the complete failures drops the percentage of homeruns from from 7.6% in the baseline to 3.8% in the worst case. So in some sense, the market is only half as good.  Even then, a portfolio of 200 investments has less than a 5% chance of losing money and a portfolio of 500 investments has less than 1% chance. Diversification still provides decent protection.Also consider that the most likely cause of such an awful angel market would be macro events that affect the entire economy.  The NASDAQ and S&P 500 would probably not be doing well either.

I think this analysis shows that diversification is a good idea even if you think the future angel market may fluctuate. This conclusion isn't at all surprising.  Fundamentally, diversification reduces volatility.  If you think the future market might differ from the past market, that means you believe the market is more volatile.  Therefore, diversification is actually more important.

[Note added 4/3/2013: here is the Excel file I used for these simulations.][Updated 4/25/2013: corrected minor error in spreadsheet and graphs.]